The SpaceX IPO Could Blow Up This Mega-Popular Investing Strategy

Investing in index funds like the Vanguard S&P 500 ETF (NYSEMKT: VOO) and the State Street SPDR S&P 500 ETF (NYSEMKT: SPY) has proven to be one of the best strategies of all time.

These index funds give you exposure to the S&P 500 (SNPINDEX: ^GSPC), or 500 of the top publicly traded American companies across a range of sectors as curated by S&P Global, making them an easy way to get diversification and growth. The S&P has long had strict criteria for its membership to ensure that the index only contains the most qualified companies.

The requirements to be considered include:

• Minimum market cap: The actual number varies, but was recently around $15 billion. If a company falls below that level, they are at risk of being removed from the index.
• Profitability: Companies must have positive generally accepted accounting principles (GAAP) earnings in their most recent quarter and positive earnings over the trailing four quarters.
• Liquidity and public float: At least 50% of the company's outstanding shares must be available for public trading, and certain volume trading standards need to be met, including at least 250,000 shares traded every month for the last six months.
• Headquarters: Must be headquartered in the U.S. and have a plurality of its fixed assets and revenues in the U.S.

Those rules, along with regular rotations to refresh the index, have helped ensure the continued success and strong performance of the S&P 500, which has historically returned 9%, beating nearly every other major asset class.

Image source: Getty Images.

A break from tradition

Now, the S&P 500 is set to throw those standards out the window. SpaceX Founder and CEO Elon Musk asked the indexes to include his space exploration company as a criterion for going public, and they have complied. Additionally, the Nasdaq-100 will "fast-track" SpaceX to be included in its index, meaning the popular Invesco QQQ Trust (NASDAQ: QQQ) will also hold the stock sooner than it normally would.

However, SpaceX, which is set to become the biggest IPO ever with Musk and his team seeking a valuation of $2 trillion, is lacking on a number of the S&P 500's requirements, which are designed in part to steer clear of volatile IPOs.

SpaceX is not GAAP profitable and most shares are expected to remain in private hands after the offering, as Musk currently owns 85% of the company.

Because the S&P 500 allocates weight based on float-adjusted market-cap, SpaceX will have a much smaller allocation in the S&P 500 and index funds than it would if most of the company were publicly held. For example, if the offering raises about $80 billion, SpaceX would have an initial weight of about 0.14%, less than the average S&P 500 stock, but that could go significantly higher if insiders dump their shares.

At the lower amount, it will still force index funds to buy a substantial amount of the stock, even though it doesn't meet the standards of the index. The index funds may also have to buy them at an artificially elevated price, as IPOs often pop after their debut before cooling off.

There's a good argument that SpaceX is overvalued at a market cap near $2 trillion as well. Morningstar, for example, valued SpaceX at just $780 billion, less than half of what the company thinks it's worth.

At the valuation it's targeting, SpaceX would have a price-to-sales ratio of roughly 100, more than any other S&P 500 company, and it is not growing particularly fast, with revenue up just 15% in the first quarter. Its recent acquisition of xAI also means that profitability is likely at least a few years out, despite its ownership of the profitable Starlink satellite internet business.

What it means for investors

A 0.14% allocation isn't going to blow up the S&P 500 index funds on its own, but it creates a dangerous precedent for future IPOs and waters down the qualities that have made the S&P 500 and the QQQ so successful.

Investors who primarily use index funds may want to consider diversifying away from them. Some options are other large-cap ETFs like the Roundhill Magnificent Seven ETF (NYSEMKT: MAGS) that tracks the Magnificent Seven stocks or sector-specific ones like the Technology Select Sector SPDR Fund (NYSEMKT: XLK) that track tech stocks.

Pushing a valuation near $2 trillion, I think SpaceX is likely to underperform as a public company. Index investors can avoid some of those headwinds by diversifying to funds that don't own SpaceX, or blue chip stocks like Nvidia.

Jeremy Bowman has positions in Nvidia. The Motley Fool has positions in and recommends Nvidia, S&P Global, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.